In July, home prices were mixed on a seasonally adjusted basis. The Case-Schiller Composite 10 City index (C-10) fell a slight 0.12% on a seasonally adjusted basis, and is down 3.77% from a year ago. The broader Composite 20 City index (which includes the cities in the C-10) edged up by 0.05% on the month and is down 4.16% from a year ago.

Prices for both indexes rose by 0.9% for the month on a not-seasonally-adjusted basis (which is how you will probably see most of the reports presented). Of the 20 cities, nine were up on the month-to-month basis (seasonally adjusted), and eleven were down. Year over year, though, 18 were down, and only Detroit and Washington DC made it into the plus column.

The overall indexes are down 31.99% (C-10) and 31.75% (C-20) from the (April 2006) bubble peaks. They set an interim low in May 2009 and rallied into the summer of 2010 before turning down again. The bounce has mostly faded.

The C-20 index set a new post-bubble low in June, and is just 0.03% above the May 2009 level. The C-10 has only a little bit more breathing space before setting a new low, up just 1.35% since that interim bottom. The earlier bounce was due to extraordinary government support in the form of an $8,000 tax credit to home buyers.

Results with Serious Lag Time

The Case Schiller data is the gold standard for housing price information but it comes with a very significant lag. This is July data we are talking about after all, and it is actually a three-month moving average, so it still includes data from June and May. The spring selling season was a bit of a bust for both new and used homes, and it doesn’t look like the summer went any better.

While the inventory to sales ratio for used homes is down from the year-ago record peak of 12.5 months, it is still elevated at 8.5 months (August). I don’t think second leg in the housing price downturn is over, but we are probably getting very close to the bottom.

The first graph (from this source) tracks the history of the C-10 and C-20 indexes. Note that on both indexes we are almost back to the post-crash lows. It seems likely to me that we will set new lows before the second leg down is over. Still, if you are looking at a house as a place to live, not purely as an investment, it is safe to go ahead and buy.

Also, we are talking about the national indexes here, and even the individual city data is for entire metro regions — and as the saying goes, real estate is all about “location, location, location.” The national headwinds are not longer so strong as to overwhelm local considerations.

Results by City

Of the nine cities that posted month-to-month gains, Detroit led the way with a 1.73% rise. DC was the next best a 1.43% rise on the month, followed by New York, up 0.36%, Chicago, up 0.29% and Dallas, with a rise of 0.15%. On the downside, the worst hit were some of the old poster children of the housing decline: Phoenix was the hardest hit, falling 1.09% for the month. San Deigo followed with a drop of 0.95%. San Francisco, down 0.81%, Las Vegas, off 0.74% and Los Angeles down 0.65% were also noticeably weak.

On a year-over-year basis, Detroit was the strongest city by far with a 1.15% rise. The only other city with a year-over-year increase was DC with a 0.24% rise. The cities that manages the smallest declines were Boston, down 1.99%, Denver, off 2.15% and Dallas with a 3.28% drop.

Worst hit on a year-over-year basis were the Twin Cities of Minneapolis-St. Paul, off 9.25% from a year ago, followed by Portland, Oregon with a 8.49% decline. Phoenix fell 8.87% while Chicago was down 6.78%, and in Seattle prices are 6.47% lower than last year.

The graph (also from this source) below tracks the cumulative declines for each city over time. If the red bar is shorter to the downside than the yellow bar for a city, it indicates that prices in that city have risen since the start of this year (not year over year).

In every city prices are below where they were in April 2006, but there is a huge variation. Las Vegas is the hardest hit, with prices down 59.46% from the peak, followed by Phoenix down 56.20%. Miami is almost a member of the “half off club,” down 49.40%. Tampa (down 46.20%) and Detroit (down 43.46%) are not far away from joining that rather dubious group.

At the other end of the spectrum, there is just one city that has managed to avoid a double-digit decline: Dallas, where prices are down only 7.51% since April 2006. Only four others are down less than 20%: Denver is off 10.89% from the national peak, with Charlotte right behind it with a 10.99% decline. Boston, off 14.93% and Cleveland, down 19.06%, fill out the list.

Please note the percentage declines I am quoting are from when the national peak was hit, the numbers in the graph are relative to that city’s individual peak, so there is a little bit of difference. Also keep in mind that these are nominal prices. While inflation has been low over the past few years, it does add up, so in real terms the declines are much greater.

No Traction Post-Tax Credit

Sales of existing houses simply collapsed in July 2010, after the homebuyer tax credit expired, and have remained depressed ever since. The extremely high ratio of homes for sale to the current selling pace is sure to put significant downward pressure on prices.

Existing home sales in August did show a little bit of a bounce, and the months supply declined to 8.5 months. That is still high enough to indicate downward pressure on prices (normal is about 6 months) but is at least moving in the right direction.

There is still quite a bit of “shadow inventory” out there as well. That is, homes where the owner is extremely delinquent in his mortgage payments and unlikely ever to make up the difference, but that the bank has not yet foreclosed on, or foreclosed houses that have not yet been listed for sale. It also includes all those people who think that the decline in housing prices is just temporary, and are waiting for a better time to sell.

I had been thinking that the decline would last through the end of the year, but that the size of the declines from this point would be limited. After that, I expect a prolonged period of essentially flat prices for existing homes, not a sharp rebound. The flat period may well be coming sooner than I expected, but it is still too early to be sure.

2nd Leg Down Won’t Be As Deep

We are unlikely to have a decline anything like the first downdraft in housing prices. The reason is in the next graph (also from this source). People need a place to live, but they do not have to own a house; they have the option of renting. A house is a capital asset, and the cash flow from owning that asset is in the form of rent you do not have to pay.

One of the clearest signs that we were in a housing bubble was that the prices of houses got way out for line with rental prices. While on this basis houses are not yet “cheap” nationally, neither are they absurdly expensive the way they were a few years ago.

If prices fall too far from here, it will become cheaper to own than rent, and lots of people who are now in apartments will start to buy. This graph also includes the CoreLogic housing price data which is similar to the C-20. Rental vacancy rates have started to fall significantly, and in many areas of the country rents are rising, not falling.

The price-to-rent ratio is already at the high end of normal based on the Case Schiller index, and in the middle of the normal range based on the CoreLogic index. Rising rents will move the ratio toward the middle or even low end of the range without more weakness in housing prices. The apartment oriented REITS such as Equity Residential (EQR) should benefit from this.

With existing homes, not the volume of turnover that is important, it is prices. The level of existing home sales is only significant relative to the level of inventories, since that provides a clue as to the future direction of home prices. If there is an excess inventory of existing homes, then it makes very little sense to build a lot of new homes.

It is the building of new houses that generates economic activity. It is not just about the profits of D.R. Horton (DHI). A used house being sold does not generate more sales of any of the building products produced by Berkshire Hathaway (BRKB) or Masco (MAS).

Turnover of used homes does not put carpenters and roofers to work — new homes do. When new home construction picks up, it could do so in a very big way (at least percentage wise) from the current extremely depressed levels, and the national homebuilders will probably pick up market share as hundreds of small mom and pop home builders have gone out of business in this downturn. A doubling in new home construction would still put the level of construction at historically very low levels, and many of the national builders could see their revenues triple or more.

Home Prices and the Evaporation of Wealth

Existing home prices are vital. Home equity is, or at least was, the most important store of wealth for the vast majority of families. Houses are generally a very leveraged asset, much more so than stocks. Using your full margin in the stock market still means you are putting 50% down. In housing, putting 20% down is considered conservative, and during the bubble was considered hopelessly old fashioned.

As a result, as housing prices declined, wealth declined by a lot more. For the most part we are not talking vast fortunes here, but rather the sort of wealth that was going to finance the kids college educations and a comfortable retirement. With that wealth gone, people have to put away more of their income to rebuild their savings if they still want to be able to send the kids to college or to retire.

That which you save you don’t spend, and if everyone starts to spend less at the same time, the economy will inevitably slow. While thrift may be a virtue on an individual level, it can be a vice at the macro level. Or, to be more precise, the change in the attitude towards more thrift can be a vice at a macro level.

The decline in housing wealth is a very big reason why retail sales have been so weak. With everyone trying to save, aggregate demand from the private sector is way down. If customers are not going to spend and buy products, employers have no reason to invest to expand capacity. They have no reason to hire more workers.

Housing Investment

People pulling money out of their houses was a big force behind what growth we had during the previous expansion. Mortgage equity withdrawal, also known as the housing ATM, often accounted for more than 5% of Disposable Personal Income during the bubble, thus greatly lifting consumer spending.

Since the bubble popped, people have been on balance paying off their homes (or defaulting on them through foreclosures). The comparison of the next two charts shows how important housing wealth is to the middle class. The first graph includes home equity wealth, the second looks only at financial assets like stocks. The upper middle class (50 to 90% income brackets) had 26% of the total wealth in the country in 2007, and just 9.3% of the wealth in the form of financial assets. The value of non-financial assets, mostly home equity, has declined significantly since 2007, and with it the wealth of the middle class.

Also, as housing prices fell, millions of homeowners found themselves owing more on their houses than the houses were worth. That greatly increases the risk of foreclosure. If the house is worth more than the mortgage, the rate of foreclosure should be zero. Regardless of how bad your cash flow situation is — due to job loss, divorce or health problems, for example — you would always be better off selling the house and getting something, even if it is less than you paid for the house, then letting the bank take it and get nothing.

By propping up the price of houses, the tax credit did help slow the increase in the rate of foreclosures. Still, more than a quarter of all houses with mortgages are worth less than the value of the mortgage today. Another five percent or so are worth less than five percent more than the value of the mortgage. If prices start to fall again, those folks well be pushed under water as well.

Downturn Not Quite Over Yet

Despite the seasonal bounce in the unadjusted numbers, the second down leg in prices is probably still underway. And while it will probably be a much shorter leg than the first one, it is still bad news for the economy.

Eventually, a growing population and higher household formation will absorb the excess inventory. The key to higher household formation (“economist speak” for getting the kids to move out of Mom and Dad’s basement and into a place of their own) will be more jobs. Unfortunately, residential investment is normally a key source of jobs when the economy is coming out of recessions. Sort of a tough “chicken and egg” problem.

If the stabilization of existing home prices can continue, and not just because of an expensive artificial prop, it is extremely good news for the economy. It will stop the foreclosure problem from getting worse, since being “underwater” is a necessary, but not sufficient condition for a foreclosure to happen. It means that the wealth of the average American is not being eroded. That should help consumer confidence.

It also lays the foundation for a pick up in new home construction. When that happens, the economy will see a huge benefit. This recovery has been lacking the normal locomotive, residential investment, which historically has pulled it out of recessions. When that locomotive gets back on track, the economy will pick up speed.

Three months of ever-so-slight improvement on a seasonally adjusted basis is not enough to declare the end of this downturn, but it sure is a hopeful sign.